That is one way of saying that China has started looking for alternatives to the dollar.

The dollar fell the most since September against the currencies of its six biggest trading partners after Chinese officials signaled plans to diversify the nation’s $1.43 trillion of foreign exchange reserves.

[…] “We will favor stronger currencies over weaker ones, and will readjust accordingly,” Cheng Siwei, vice chairman of China’s National People’s Congress, told a conference in Beijing. The dollar is “losing its status as the world currency,” Xu Jian, a central bank vice director, said at the same meeting.

[…] Chinese investors have reduced their holdings of U.S. Treasuries by 5 percent to $400 billion in the five months to August. China Investment Corp., which manages the nation’s $200 billion sovereign wealth fund, said last month it may get more of the nation’s reserves to invest to improve returns.

However:

“The world’s currency structure has changed,” Xu said at the conference in Beijing. Cheng, speaking to reporters after his speech, said his comments don’t mean China will buy more euros. The National People’s Congress, China’s legislature, isn’t involved in setting currency policy.

“Cheng has a history of speaking out on a range of financial market and economic developments, and his comments are not always accurate,” said Glenn Maguire, chief Asia economist at Societe Generale SA in Hong Kong.

Cheng’s remarks on Jan. 30 that China’s stock rally was a “bubble” caused the benchmark index to fall the most in almost two years the following day. The Shanghai and Shenzhen 300 Index, then over 2,500 points, has since climbed above 5,300.

I feel like I ought to be worried about this, but I also feel as though I don’t know enough about the situation to comment authoritatively. Let’s split the difference – I put the story up and better informed readers can hash out what it means in the comments.

The problem with China moving out of dollars has been predicted forever, and it’s a serious one. But they’re not the real 800-lb. gorilla for the US dollar.

Oil is. Oil at $90/bbl. is a problem for us. But imagine the problems of the finance minister for Saudi Arabia; your prime export is priced in dollars, which seem to be sinking faster than the commodity price is rising. All oil traded today on the global market is priced in dollars — and this means that the world oil supply in effect is backing the value of the dollar.

If major oil producers, fed up with the shrinking dollar, decide to start marketing their oil in Euros, yen, or renminbi or whatever, then the bottom is really going to fall out from under the US currency. Then we’re really going to see inflation.

Who cares about China or Saudi Arabia.Gisele is refusing to be paid in dollars, she wants euros instead. Since she’s a famous model, that will actually be reported in the news, unlike more serious matters.

We are the only central bank dropping interests right now. Everyone else actually has real inflation metrics (as opposed to the US “measure everything except what people actually spend money on”) and are actually raising rates to do something about it.

Are we up to 5 now? When will the number of World Wars exceed the number of Rocky Movies?

On a slightly more optimistic note, a weak US dollar does mean that foreign imports start getting more expensive and US exports start looking like they’re going on fire sale. So suddenly all those American made trade goods and harvested resources look like bargins on the world market and we can expect to start righting that trade deficit we’ve been digging ourselves into.

Actually, it occurs to me that America doesn’t produce anything locally anymore, as all our major corporations have decided to off-shore labor to such corporate havens as India and China. So now the price of everything sold in America is STILL going to skyrocket. Fuck. I guess we really are screwed.

Welcome to the result of building an economy around credit. I guess the nation is a reflection of it’s people though since this is how most people live their lives. I predict that if this doesn’t get corrected by some sane economic policies or the development a phenomenal energy technology, we will be a 2nd world nation within 20 years.

I am an expert. I’m an expert in knowing that if you don’t make, do, or grow something that people want to pay for and you instead buy everything from someone else and pay them in IOU’s you will eventually be fucked.

If the portion of the National Debt for every man, woman and child in your country stands at $29,944.90 and rising then you’re double-fucked.

If your President’s economic team is just as sharp as his legal and diplomatic teams well…

I’m not an expert here at all but I wonder if the risk is overblown a bit. I think the US & China have a symbiotic (although probably unhealthy) relationship. China provides the US with cheap goods while the US provides China with a seemingly endless supply of consumers who will spend every last dime (borrowing all the way).

China does it’s part by pumping the US with credit by buying dollars to drive up the purchasing power of Americans, and the US turns around & send that money right back to China via import purchases.

I think they’d (China) would be cutting off their nose to spite their face, if they went the diversification route in a big way. It seems like it might only make sense if they can replace the consumers with consumers from somewhere else & I’m not sure where they’d find as spend-happy an audience.

Let me get this right – China has pegged its currency to the dollar and wants to diversify its holdings out of dollars – uh, how? We account for more than 70% of all their foreign sales; no doubt this is a shot across bush’s bow to get even for the US congress talking about their artificially low currency … . What’s next, they will only sell to us if we give them Euro’s ?… no, wait, they will stop buying our debt and let our economy fall so we stop buying their junk … no, wait, they will start exporting Chinese organs to finance their economy and reduce their massive population of poor peasants (over 300 million living on a dollar a day and their numbers are climbing faster than the State can support even that meager level).

BFR, while I’d love to be comforted by your analysis I would mention that the opportunity to catastrophically damage the world’s largest Anglo nation might be enough. The opportunity to defuse the tension between the rising class of wealthy entrepreneurs and the mass of struggling peasants would add a frisson of historicity to such a move. The leadership of China might decide that to lop off the heads of the few wealthy in return for a severe blow to Capitalism and the loyalty of the myriads of the underclass might just be worth it.

I think they’d (China) would be cutting off their nose to spite their face, if they went the diversification route in a big way.

This is the great “decoupling debate”. Can China decouple? There are good arguments either way.

That doesn’t change the fact that we are screwed. The question is whether the coming recession (or Great Depression II if you follow the bear blogs) will just be the US, or if we will take the rest of the world with us. The data certainly suggests that if we go down, so will many others. Europe’s housing bubble is actually worse than ours is (believe it or not).

Dennis – the wealthy entrepreneurs (not to mention rising middle class) are just as Chinese as the struggling peasants. Sending these people into abject poverty to make a political point might buy you some cred with the peasant class (I’m skeptical) for a while but it’s just not a rational approach if your goal is to stay in power for a long time.

Like them or not, I don’t see much coming out of China that strikes me as irrational – if they were, they would have invaded Taiwan a long time ago.

I am an expert. I’m an expert in knowing that if you don’t make, do, or grow something that people want to pay for and you instead buy everything from someone else and pay them in IOU’s you will eventually be fucked.

These are pretty valuable commodities. No, the supply chains are not all within the US, but that doesn’t change the fact that foreigners can and do send lots of money to the US and to US entities to buy these things. We also host capital markets that are generally considered business friendly, transparent & trustworthy. I don’t think Bush has wrecked this (yet).

Uh, folks? China isn’t another Asian dragon (like singapore, south korea, malaysia, etc.) that we can push around. Yes, the US consumes %70 of Chinese exports. But big deal. %90 of Chinese products are purchased domestically (domestic to China), even more if you count the huge amount of black market goods sold in open-air markets. Frankly, the Chinese economy could use the cooling provided by a weak dollar.

The crux here isn’t about imports/exports, it’s that China holds most of the national debt. By inflating our currency, we’re basically trying to reduce the debt they hold by making it worthless. So China has to do its best to prop up the dollar or else write off all that money as bad debt, which they’re loathe to do, because it would bankrupt their government at a time when it’s already fragile and civic unrest is increasing. But if Beijing ever manages to consolidate domestic power — watch out. Tanking the US economy has a lot of advantages for China internationally. For one, would let them run wild all over East Asia — we wouldn’t be able to pay our soldiers to fight them.

Yes, but it bears mentioning that one of the effects of this is that Canadians are spending more money in the US, including purchases of US real estate

Great! Then the Chinese and Saudi’s won’t own everything! I must be getting old because I still think it was better for us blue collar types when we exported instead of imported and were able to afford our own real estate. I don’t want an economy dependent on tourism and foreign capital.

BFR, the Chinese are monolithic in many ways but very capable of making class distinctions. Witness, the Mandarins. The Chinese have been historically accommodating to class distinctions but not when the mass of the Chinese people feel that those distinctions are not in the best interests of China as a whole.

I recently heard, on NPR, a Chinese Levelist mention that the current regime had lost the Mandate of Heaven. I was startled to hear such an ancient concept stated in 2007. If the person who said that wasn’t some anomalous historian then the whole thing is up for grabs.

Doubting Thomas, it’s been only 31 years since the Canadian dollar was last at par with the American dollar.

Now, it did peak at a record-breaking $1.104 earlier today, before (thankfully!) sagging back to $1.075, and it could peak higher yet, but as a Canadian with some major manufacturers among my clients, I don’t want a runaway dollar. I’d like a nice little vacation in New York next spring with my dollar within a few cents of par either way. A loonie worth US$1.50 would make it very likely that I would be having a very long vacation at home.

I recently heard, on NPR, a Chinese Levelist mention that the current regime had lost the Mandate of Heaven. I was startled to hear such an ancient concept stated in 2007.

Ok, but I recently saw a bunch of US presidential candidates implicitly claim that the earth was made in 7 days 6000 years ago. I don’t know who it was that was speaking on NPR nor am I an expert on China but it seems fairly clear that an assault on the US economy would lead to substantial near term hardships for a lot of Chinese people. I don’t see any evidence that the Chinese government (in it’s current incarnation) is irrational, so I don’t think there’s much of a chance that they would risk destroying the economic arrangement they have with the US, at least in the near-term.

Hey, Frank: Here’s a couple of explanations. Pick one or make up your own.

1) The Chinese government isn’t “China” as a whole, it’s a specific group of individuals who have individual interests. Particularly, they want to keep their grip on power. To do this, they need a strong central government. Tanking the dollar (by declaring the loans bad debt or even by refusing more loans) would significantly weaken the central government. The central Chinese government has never been powerful (not since Qinshi Huangdi 2200 years ago) and the present government is particularly weak and embattled. The collapse of the dollar might well kill the government.

I think that Americans (who have a comparatively strong, stable central government) have a difficult time understanding just how weak and unstable the governments of some other nations are.

2) China is planning on dumping the dollar any time now, in order to bankrupt the US, leading to a collapse of the US military, without whose presence in the region they could invade and occupy Taiwan, the Koreas, and Mongolia.

(…)A trade deficit this big cannot persist indefinitely. Many analysts hope that the necessary real depreciation of the dollar might be gradual. After all, isn’t the avoidance of such jumps one of the reasons we abandoned the Bretton Woods fixed-exchange system for a floating regime? So why are there modern fears of a sudden discrete drop in the dollar?

Im going to take these in reverse order since the second is the more important.

2 Is a paranoid xenophobic POS. Not that it hasnt crossed my mind and the minds of many others. If you see the world as a board game it even makes strategic sense.

But none of that is even necissary. If the Chinese want to get paid for their valuable goods and services they can’t keep accepting worthless IOUs.

1 There is no inherent reason why stopping the purchase of treasuries has to weaken the Chinese central government, or more importantly the Chinese Comunist Party. Its true that they want to keep people working in their export industry, but they could do that in other ways. Hell they could just dump the goods they were going to send to US into the sea. And they should if the attitude I’m seeing here about stiffing them has any real currency.

Europe’s housing bubble is actually worse than ours is (believe it or not).

You have to be kidding me. Do you have a ref for that?

I mean worse in the following sense: the prices of homes in Europe have deviated much further from historical norms than they have in the U.S. London is currently at a multiple of 10 when you compute the ratio of house cost to salary. That’s more than the craziest California numbers (cannot find right now, but I think they are 8-9). And they don’t even have an interest deduction for mortgages! Sane numbers are 3-4, if you take the US income tax deduction into account.

England has fueled their property lander by buying a lot of foreign properties. My understanding is that Florida is screwing a lot of English owners (I have this impression through broker comments on Calculated RIsk, and so cannot find a definitive like right now). They have also bought a lot in Spain, which has seen California level run-ups over 8 years. In fact, if you look at that article, the key paragraph is

The Economist notes that the ratio of house prices to income in Spain (average house price divided by average income) is already at its highest level ever and 68 percent above its long-term average. In the United Kingdom, Ireland and the Netherlands the average is 50 percent above its long term average and in the US it is 23 percent above. There are also more than 3 million empty new homes in Spain and owners may try to sell them as they realise that prices are about to come down, causing a further drop in prices.

So, in terms of affordability, the housing situation is much better in the US than in Europe. The difference is that while we relied on subprime loans to pull poor people into the real estate ponzi scheme, they relied on investment in other countries. We go down, freeze up the lower rungs of their ladder, and then they fall.

Exactly how is it rational for China to accept an
endless stream of depreciating IOUs with no intrinsic
worth in return for real goods and services which
require actual labor and capital to produce?

Manufacturing crap for Wal-Mart keeps lots of Chinese workers employed. Even at a loss. China sees the equivalent of the adult male population of Great Britain move to the cities from the countryside every year. Those people either get jobs in factories, or they get pissed off and riot. Taking a haircut on American debt that keeps depreciating is worth it … up to a point.

And that’s one of the more interesting $64,000 questions. Where is that point?

And that’s just the China part of the equation. As others have pointed out upthread, we as a nation have mortgaged our future. In a huge way, and in a way totally unprecedented in all of our history from 1790 to 1970. Behold our trade deficit. Behold, too, the decline in manufacturing jobs.

We are not fucked, exactly. But many foreign hands have a tight grip on our tender jiggly bits. And their grip grows tighter by the day.

“England,” and even “United Kingdom,” does not equal “Europe.” I’m prepared to believe that “Europe” has a housing bubble, I guess, but I’d like to see evidence that extends beyond a set of islands off the coast of Europe.

1. China probably won’t do anything unless we look like we are, in fact, about to attack Iran. Iran and China having signed quite a few energy deals, I can see China not being too happy about this.

2. From all that I’ve heard, the Chinese government has pretty weak control over exactly what the lower-down politicans and governing bodies do when dealing with the hoi polloi. What China fears, more than anything else, is the populace getting restless–because they know damn well that if a sizable percentage of the population wants to overturn the apple cart, there’s not much they can do about it. Heck, if South China decides it wants to go gang-busters for growth, there’s not much they can do about it.

3. Several years ago visited Guang-Zhou. Was quite surprised at how open the people were there about how they couldn’t stand the bastards in Beijing. Regional strains between north and south, coastal and inland–the Chinese gov’t is in a continual rush of madly juggling plates, hoping that they won’t drop anything. They’re worried about continuous demands for energy (coal, nuclear, and oil), pollution problems, infrastructure, and having to keep the natives from rebellion. ALL the time.

“England,” and even “United Kingdom,” does not equal “Europe.” I’m prepared to believe that “Europe” has a housing bubble, I guess, but I’d like to see evidence that extends beyond a set of islands off the coast of Europe.

I gave you links for Spain and Netherlands in the previous post. Norway is also insane; on page 23 of this pdf from Shiller you can see that their increase is 50% again the run up in the US. And here you can find out about the eastern Europe housing bubble.

Oh, and London housing prices are nutty, but London housing prices have always been nutty.

Go back and read that paragraph again. 50 percent above its long term average. That takes into account traditional nuttiness in their market.

Norway is also insane; on page 23 of this pdf from Shiller you can see that their increase is 50% again the run up in the US.

Whoops. Bad math. That’s embarrassing. I was just looking at the final numbers, not the start. The US and Norway both start normalized on that graph at 100. US goes to 200 and Norway to 300. That means the Norway run-up has been twice the US, not 50%.

On a slightly more optimistic note, a weak US dollar does mean that foreign imports start getting more expensive and US exports start looking like they’re going on fire sale. So suddenly all those American made trade goods and harvested resources look like bargins on the world market and we can expect to start righting that trade deficit we’ve been digging ourselves into.

Dude – “capital flows”. Your trade deficit problems aren’t going to go away as long as you need more investment funds in your economy than you are saving domestically.

The public debt as a % of GDP works out to less than 100%, meaning, we owe less than a year’s worth of economic output. This figure compares favorably with Europe, I believe. The federal budget deficit as a % of GDP is well below historical peacetime highs.

When you buy your first house, you borrow many years worth of your own economic output. It is easy to blow the debt out of proportion.

That being said, a credit squeeze could really crush growth, and any stimulus (lowering interest rates or Keynesian spending) we might choose could, in combination with the dollar no longer being the dominant reserve currency, could create simultaneous inflation. Viola, stagflation. Back the the 70s. Poor people will suffer and the rest of us have to buy fewer nice things. But the idea that we will be a 2nd rate nation with our human, technological, and financial capital is ridiculous.

A related question is, if a real economic crisis comes that requires raising taxes on high incomes, will the super-rich be loyal Americans or traitors?

I think it gets interesting when when inflation gets to the point that our outstanding debt (on course for 10 trillion) starts to depreciate at a rate of ~1 trillion per year. We should be on course for that. At that point we will need to come up with 1 trill per year to cover the interest plus about 1 trillion/per year to keep the deficit the same. Since we switched over from bonds with a 5-10 year maturity to bonds with a 2-3 year maturity, we will need about 6 trillion a year in financing. We already borrow about 80% of net global savings while only having needed less than 3 trillion in financing up till now. I’d count on the US dollar losing at least half its value as foriegn exchange in the next few years. Really just a repeat of the double digit inflation we had for the decade after vietnam our last losing land war in Asia. Unless the Chinese decide to make it personal.

I believe there is a possibility in technology. America still has some of the most brilliant minds in cutting edge science and large scale corporate robbery. A revolutionary energy product could erase the entire debt if marketed properly and coupled with a strict budget. Or not.

My only consolation is that soon the DC crowd will find the dollars they pay their security to keep the rabble from lynching and burning them is not going to be worth the asses they will be wiping soon enough at this rate.

When your currency drops 35% in value relative to the rest of the world in a year and looks to keep on going…

Let’s not forget 2 other ‘gifts’ from the Bush administration that will contribute handily to our being economically fucked.

Unlike the 70’s, we have a whole lot more senior services to pay for. They are already eating up a huge chunk of our tax revenue and growing. Adding fuel to the fire is the lovely medicare part D.

Plus, let’s also not forget that we have been such stellar technology developers because for the last 60 years, we’ve had no trouble importing our geniuses. Now that the US is becoming an international pariah, fucked up its Visa system, started claiming it has the power to infinitely detain legal aliens, and lets its customs folks treat visitors like excrement, the more brilliant students are second guessing whether to attend universities in the US.

In the long run, these things will screw us over the most in my opinion.

It was mentioned in passing, but it is worth noting that many of the US companies that export actually import many of the raw materials and labor (by building abroad), so a weak dollar means their costs go up.

In a very simple econ 101 view, a cheaper dollar makes our exports cheaper, but when you realize that those exports are made from imports, it gets much more complicated.

Agriculture is one thing that is truly made in the US, but if making those exports cheaper was a real positive, all we’d have to do is stop propping up those prices with subsidies.

Having China hold such a large portion of our debt is a serious issue. Regardless of their intent it clearly gives them too big a lever to pull should they want to. If their leadership is rational they will continue to fund our debt if it appears to be to their advantage – when it becomes a less favorable or advantageous option they probably won’t. If their leadership is NOT rational, well, all bets are off.

I’m not warmed or comforted by our economy being subject to the whims or preferences of a country of the size and type of government as China.

Rational leadership is a valuable commodity. Maybe we should try it next time around instead of voting for a guy because he “acts tough” or seems like a guy you’d want to have beer with.